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Tuesday, June 10, 2014

Unpicking Piketty

Once upon a time, there was an obscure French mainstream economist who
collaborated with others (Emmanuel Saez, Anthony Atkinson and Gabriel
Zucman) on various studies of inequality of income and wealth in modern
economies like the US. After some years of research, this Frenchman
developed a theory that the inequality of wealth in capitalist economies
tends to increase to the point where it could cause major social
instability. This tendency is the “central contradiction of capitalism”.

That economist is Thomas Piketty. When he published his magnum opus
of 677 pages in France last October, it was greeted pretty much with
silence and even cynicism, apart from a few French economists. But then
it was translated into English and published in America. Everything
changed. It became not just the best-selling economics book, but the top
non-fiction book of the year, ahead of cook books by famous chefs and
travel books by celebrities.

There has been a profusion of reviews, debates and interviews with
the man of the moment. The book has been greeted rapturously by such as
Branko Milanović, the expert on the inequality of wealth in the world,
who called it “one of the watershed books in economic thinking”,1 and by the guru of liberal Keynesian economics, Paul Krugman, who, writing in the New York Review of Books, said it was “truly superb”.2 Martin Wolf of the Financial Times called it “extraordinarily important” and “awesome”.3 John Cassidy, in the New Yorker, said: “Piketty has written a book that nobody interested in a defining issue of our era can afford to ignore.”4

The title is a clear allusion to Karl Marx’s Capital,
published in 1867. Piketty seems to suggest that he is updating (and
indeed correcting) Marx’s analysis of 19th century capitalism for the
21st century. But Piketty is no Marxist.

He was brought up in Clichy, a mainly working class district of
Paris. His parents were both militant members of Lutte Ouvrière
(Workers’ Struggle) - a Trotskyist party, which still has a significant
following in France. On a trip with a close friend to Romania in early
1990, after the collapse of the Soviet empire, he had a revelation:
“This sort of vaccinated me for life against lazy, anti-capitalist
rhetoric, because when you see these empty shops, you see these people
queuing for nothing in the street,” he said, “it became clear to me that
we need private property and market institutions, not just for economic
efficiency, but for personal freedom.”5
Piketty rejected what he saw as Marxism and opted for social reform.
Indeed, he was an adviser to the Blairite, Ségolène Royal, when she was
the Socialist Party candidate in the 2007 presidential elections.

Why ‘Marx is wrong’
According to Piketty, Marx needs correcting because, despite his
clever intuition that “private capital accumulation could lead to the
concentration of wealth in ever fewer hands” (p1), he got the whole
mechanism for this development totally wrong. Marx thought that
capitalism would have an “apocalyptic” end, but, thanks to “modern
economic growth and the diffusion of knowledge”, that has been avoided.
But there is still the problem of the “deep structures of capital
inequality”.

Piketty goes on to inform us that the basis of Marx’s prediction of
an apocalyptic end to capitalism was “either the rate of return on
capital would steadily diminish (thereby killing the engine of
accumulation and leading to violent conflict among capitalists) or
capital’s share of national income would increase indefinitely until the
workers went into revolt” (p9).

Marx reckoned that wages would be stagnant or falling. This was
wrong, because “like his predecessors, Marx totally neglected the
possibility of durable technological progress and steadily increasing
productivity, which is a force that can to some extent serve as a
counterweight to the process of accumulation and concentration of
capital” (p10). Unfortunately, you see, Marx failed to use the stats
available in the 19th century and “devoted little thought” to how a
non-capitalist society might work. If he had done so, he might have
sorted out his mistakes.

Already, it will be clear to a student of Marx’s analysis of a
capitalist economy that Piketty is unaware that Marx saw the drive to
raise the productivity of labour through technological advance as the
flipside of the accumulation of capital. Instead, Piketty accepts the
distortion by mainstream economics that Marx’s theory is based on an
‘iron law of wages’ and a zero rise in productivity: “Marx’s theory
implicitly relies on a strict assumption of zero productivity growth
over the long run” (p27).

It is not surprising that Piketty can write in such a way when we
learn that he admits he has never read the very book that carries the
same title as his own: “I never managed really to read it. I mean, I
don’t know if you’ve tried to read it. Have you tried?… The Communist manifesto of 1848 is a short and strong piece. Das Kapital,
I think, is very difficult to read and for me it was not very
influential ... The big difference is that my book is a book about the
history of capital. In the books of Marx there’s no data.”6

Again, the view that Marx’s Capital contains no data to back
up his theory of the law of value and exploitation and the laws of
motion of capitalism shows Piketty’s ignorance of the work whose name he
has adopted for his own book.

The Data Attack

Piketty’s book is bursting with data - and, in my view, this is all
to the good. Its merit is that it compiles evidence and tries to develop
a theory and laws from there. For example, he says: “All social
scientists and all citizens must take a serious interest in money, its
measurement, the facts surrounding it and its history. Those who have a
lot of it never fail to defend their interest. Refusing to deal with
numbers rarely serves the interest of the least well-off” (p577).

However, compiling lots of data can lead to errors of measurement,
difficulties in interpretation and bias in analysis. And this is exactly
where recent criticism of Piketty’s book has concentrated. The FT’s
economics editor, Chris Giles, has gone through the wealth of data
used. He found that Piketty had made simple mistakes in transcribing
some of it. He also claimed that the author had made “arbitrary” changes
in some of his estimated data without explanation. Piketty
“cherry-picked” his sources, using different measures in different
countries at different times. Giles made new calculations with other
data sources and found that there is no “obvious upward trend” in
inequality of wealth in Europe.

Piketty has vigorously defended his work from Giles’ critique and I
have sympathy with him. Data are always inadequate and often
inconsistent and it is also easy to make simple mistakes. But it is
better to try and provide evidence and, above all, release sources and
your workings for all your data, so that others can check and - even
better - try and replicate your results. That is the scientific method.
As Piketty says in his reply to Giles, at least he has put all his data
and workings online for people to consider.7
And that is more than we can say about the bulk of mainstream
economics, which either offer no evidence to back up theoretical claims
or fail to provide any workings, or both. He has been more transparent
than most with his evidence. Piketty also argues that more recent work
on inequality of wealth by his colleagues, Saez and Zucman, using
different measurement methods, “confirm and reinforce my findings”.8 So he reckons that any mistakes or biases in his own data “will not have much of an impact on the general findings”.9

Capital and wealth
In my view, there are more important deficiencies in Piketty’s work
than inconsistencies in the data. For one, there is the key difference
between wealth and capital that he ignores. For Piketty, “Capital is
defined as the sum total of non-human assets that can be owned and
exchanged on some market. Capital includes all forms of real property
(including residential real estate) as well as financial and
professional capital (plants, infrastructure, machinery, patents and so
on) used by firms and government agencies” (p46). In effect, for
Piketty, capital and wealth (mainly personal wealth) are the same: “To
simplify the test, I use the words ‘capital’ and ‘wealth’
interchangeably, as if they were perfectly synonymous” (p47).

This is clearly different from capital as defined by Marx. For him,
capital is a social relation specific to the capitalist mode of
production. Under the capitalist mode of production, things and services
that people need are produced simply as a money-making exercise, but
this money comes from value created by the exertion of labour-power,
with the surplus over and above the living needs of labour appropriated
by the owners of capital. Thus the circuit of capital, for Marx, is
M-C…P…C1 to M1: that is, capitalists have money
capital (M), which is invested in commodities (C), means of production
and raw materials, which are used by labour in production (P) to produce
commodities (C1) for sale on the market for more money (M1). Capital (M) expands value to accumulate more capital (M1). But only labour creates that new value.

For Piketty, this process of exploitation of labour and its social
relations are ignored. Capital is wealth and wealth is capital. But
wealth existed before the capitalist mode of production became dominant
in the world and is not specific to capitalism. Indeed, wealth is really
a measure of accumulated assets, tangible and financial. So for Piketty
the capital process is M…M1. Money accumulates more money
(or wealth). It does not matter how and so there is no need to define
capital as different from wealth.
This is what Marx called “vulgar economics”: ie, failing to see the
underlying process of accumulation and just observing the appearance -
indeed seeing things from the view of the holder of wealth alone. In the
book, Piketty refers us to the novels of Jane Austen and Honoré de
Balzac, where all the characters who are holders of wealth live off the
income from it (p53). All they were interested in was the return on that
wealth, not how it was generated (whether by slaves, wage labour, land
rents or interest on government debt).

Piketty specifically rules out the approach of the classical
economists and Marx: “Some definitions of capital hold that the term
should apply only to those components of wealth directly employed in the
production process … this limitation strikes me as neither desirable
nor practical” (p48). So “I ruled out the idea of excluding residential
real estate from capital on the grounds that it is ‘unproductive’,
unlike productive capital used by firms and governments … the truth is
that all these forms of wealth are useful and productive and reflect
capital’s two major economic functions.”

Well, residential property is obviously useful to the user - it has
use-value, as Marx would say. But this form of wealth is not productive
of new value (or profit), unless it is owned by a real estate company
which rents it out as a business. Nevertheless, Piketty concocts a way
for this wealth to deliver income: “residential real estate can be seen
as a capital asset that yields ‘housing services’, whose value is
measured by their rental equivalent”. Does this matter? Oh yes.

By including residential property, net financial assets and land in
his definition of capital, Piketty reaches opposite conclusions from
Marx on the return on capital, or what Marx called the rate of profit.
And that matters. For a start, it means that Piketty is interested in
the distribution of wealth and not on how it is produced. For him, the
former provides the key contradiction of capitalism, while for Marx that
contradiction lies in the latter process. For Marx, private ownership
of the means of production for profit is the major fault line in modern
society; for Piketty, private wealth is accepted forever; it is just too
unequal.R greater than g
This brings us to what Piketty designates grandiosely as his “first
fundamental law of capitalism” (p52). Capital’s share of national income
(α) is equal to the capital income ratio (β) in an economy, multiplied
by the net rate of return on capital (r). So inequality of wealth, as
expressed by capital’s share of income, will rise if the rate of return
on the existing wealth ratio (the capital income ratio) rises.
Alternatively, the wealth ratio will rise if capital’s share of national
income rises.

According to Piketty, his law is better than Marx’s law of the
tendency of the rate of profit to fall. As he says, “the rate of return
on capital is a central concept in many economic theories. In
particular, Marxist analysis emphasises the falling rate of profit - a
historical prediction that has turned out to be quite wrong, although it
does contain an interesting intuition” (p52). Marx was wrong because he
reckoned that r would fall over time and this caused recurrent crises.
Instead, Piketty tells us that actually r does not fall over time, but
rises or at least stays pretty steady. So the issue for 21st century
capitalism is: if r (the rate of return on capital) is greater than g
(net real national income growth rate), then capital’s share of income
will grow and the global capital/income ratio will eventually reach
socially unacceptable levels.

The central crisis for capitalism is thus a distributional one. When
the net rate of return on capital outstrips the growth of net national
income - ie, when r is greater than g - “the inequality r>g in one
sense implies that the past tends to devour the future: wealth
originating in the past automatically grows more rapidly even without
labour than wealth stemming from work which can be saved”. So even an
“apparently small gap between the return on capital and the rate of
growth can in the long run have powerful and destabilising effects on
the structure and dynamics of social inequality” (p77).
There is little or nothing in Piketty’s book about booms and slumps,
or about the great depression, the great recession or other recessions,
except the comment that the great recession was a “financial panic” (as
claimed by Ben Bernanke) and was not as bad as the great depression
because of the intervention of the central banks and the state. There is
nothing about the waste of production, jobs and incomes caused by
recurrent crises in the capitalist mode of production.

Instead, Piketty adopts the usual neoclassical explanation that these
events, like wars, were exogenous “shocks” to the long-term expansion
of productivity and economic growth under capitalism (p170). Crises are
just short-term shocks and we can revert to his fundamental law instead,
“as it allows us to understand the potential equilibrium level toward
which the capital income ratio tends in the long run when the effects of
shocks and crises have dissipated”. Keynes might retort: ‘We are all
dead in the long run.’

For Piketty, r>g is a tendency that is sometimes overcome by
counter-tendencies, or a divergence sometimes countered by convergence.
For example, between 1913 and 1950, r fell sharply and so in the period
after the war g was higher than r and inequality fell (see fig 1).
The other side of the coin is Piketty’s forecast that r will exceed g
for the rest of this century and thus increase capital’s share of income
and inequality.

This is because global growth will slow. Output per head has
increased on average by 1.6% a year since 1700 - half due to population
growth and half to productivity growth. Growth rates of 3%-4% only
existed for brief periods. Also “population growth is slowing from 1.3% a
year to 0.4% by the 2030s and “there is no historical example of a
country at the world technological frontier whose growth in per capita
output exceeded 1.5% over a lengthy period of time” (p93). The 20th
century saw emerging economies like Japan, Korea, China and India ‘catch
up’ with slowing advanced economies and so keep the global rate high by
historic standards. But in the 21st century there are no catch-up
economies of any size left (p97). Economies have reached the end of the
technology frontier. In contrast, Piketty claims that his r “is pretty
much steady around 4%-5%” (p55).

But is Piketty’s r steady and likely to stay so? Part of it
is made up of returns on financial capital (stocks and bonds). The
long-term return on interest-bearing and dividend-bearing financial
capital has been falling, not rising, since the 1930s.10 On current trends, it is heading for zero by 2050 - not over 4%, as Piketty projects.11
But then, Piketty’s r also incorporates a return from property,
synthetically generated as equivalent rents from ‘housing services’.
This assumes that if you own your house you are making an income from
it, even though you just live in it!

Without that, Piketty’s r would be falling, not rising. That is
because the share of housing in ‘capital’ in Piketty’s data was more
than half by 2010 compared to much less than half in 1940s. This is what
affects r. The overall value of r has not changed because land has been
replaced in Piketty’s ‘capital’ mostly by housing (p118). Farmland was
two-thirds of capital in the 18th century, but hardly more than 2% in
France and UK now: “once it was mainly land, but has become primarily
housing plus industrial and financial assets (half in half)” (p122).

This has concerned other reviewers.12
If capital includes property and net financial assets, as well as
tangible assets like industrial plant, offices, machinery and
technology, then capital values can be volatile and deliver a net rate
of return that is not steady. Piketty’s data show that the biggest
reversal of the inexorable rise in the capital income ratio in the 20th
century took place during the great depression and the ensuing world
war. This delivered a U-shape to the movement of the global
capital-income ratio (see fig 2). But from the 1950s the capital income ratio began to rise inexorably.
Piketty admits that a financial asset price bubble accounted for
one-third of that increase in national capital to national income in
this period (p91). From the 1980s onwards, where there is a big jump in
inequality, is precisely when financial asset prices boomed. Piketty
dismisses the argument that financial speculation will distort his
“steady” rate of return, because, over the long run, he expects
financial asset prices to be in line with the value of tangible assets.
But it would have to be a very long run, because in the last 60 years
that has not been the case.

r not a marginal return
This brings us to what Piketty, again rather self-importantly, calls
“the second fundamental law of capitalism”. This is β=s/g. In words: the
capital/income ratio (β) is equal to the savings rate (s) divided by
the growth rate (g) over the long run. Piketty reckons that his ‘second
law’ provides the explanation of why the global capital income ratio
will rise: net income growth (g) will slow, while the net rate of return
(r) will stabilise at a significant level above the growth rate and the
net savings rate will reach an equilibrium level over time that is much
higher than now.

Here, Piketty turns to the traditional neoclassical aggregate production function model developed by Robert Solow.13
In this model, all ‘factors of production’ make a contribution to
growth. If there is an increase in one factor relative to another in
contributing to output, then its ‘marginal productivity’ will fall. An
abundance of a factor, capital, will lead to diminishing returns on that
factor: “Too much capital kills the return on capital … it is natural
to expect that marginal productivity of capital decreases, as the stock
of capital increases” (p215). This would suggest that r should fall.
However, Piketty reckons that r will not drop fast enough to stop the
share of capital income from rising: “This implies that the capital
share in income is rising faster than the net rate of return is falling”
(p173). In the neoclassical model, this assumes an ‘elasticity of
substitution’ between capital and labour greater than one - namely that
labour will be replaced by capital quicker than the accumulation of
capital will lead to a fall in its ‘marginal product’. Actually, as
other reviewers have pointed out, there is not one empirical study that
shows such a high elasticity except Piketty’s. They all show that r
starts to fall after a while. Piketty’s answer is that over the very
long run it will not.

Anyway, this neoclassical model of growth was debunked a long time
ago. Piketty refers to the great debate between the Cambridge economists
of Massachusetts (Robert Solow, Paul Samuelson) and those of Cambridge,
England (Joan Robinson, etc), which ended in defeat for the former. The
latter group showed that, if capital is a physical entity in machines,
plant, etc, it cannot be valued in money and it cannot be infinitely
substituted for labour.14
So the theory bears no relation to reality. Piketty’s answer is to turn
to the facts. The Cambridge debate could not be resolved because of a
“lack of data”. It does not matter who was right because the
capital-income ratio has been rising in recent decades and that is all
we need to know.

In effect, Piketty dispenses with the aggregate production model that
he started to use to explain his second law: “The main problem ... is
quite simply that it fails to explain the diversity of the wage
distribution we observe in different countries at different times”
(p308). Instead he adopts an institutional explanation - that the
wealthy control government and companies and so ensure that they collect
more than their ‘just’ marginal return on capital: “There is every
reason to believe that r will be much greater than g in the decades
ahead because of ‘oligarchic divergence’” (p463). This divergence is
even greater because the rich hide their wealth in tax havens (p466).

Piketty concludes that “Top managers by and large have the power to
set their own remuneration - in some case without limit and in many
cases without any clear relation to their individual productivity”
(p24). These super-salaries are very often just “pay for luck” (p335).
So the marginal productivity of capital has nothing to do with it. In
effect, Piketty is agreeing with Marx that these obscene “wages of
superintendence of labour” (Marx’s term) are a concealed portion of
surplus value extracted from wage labour.

Marx or Piketty: whose r?
Piketty argues that Marx’s law of the tendency of the rate of profit
to fall was based on an assumption that there was “an infinite
accumulation of capital” and “ever more increasing quantities of capital
lead inexorably to a falling rate of profit (ie, return on capital) and
eventually to their own downfall, while growth in net income (g) falls
to zero” (p228). Here Piketty imposes the marginal productivity theory
of capital accumulation on Marx - the very one that he rejects for
himself: namely, that an abundance of capital leads to diminishing
returns.

Actually, for Marx, the movement in r is to be found not in “infinite
accumulation”, but in the rise in value of the means of production
relative to the value of labour (-power). Piketty says that after World
War II, capital was scarce and so the return on capital was high. Marx
would have said capital values had been destroyed (both physically and
in value), so the rate of profit was high. It was not ‘scarcity of
capital’, but the destruction of its value (by war or slump).

We can check if Marx’s law of the tendency of the rate of profit to
fall bears out in reality over the long run against Piketty’s “steady
state” r. Fig 3 shows Esteban Maito’s world rate of profit going back to 1869, using a Marxian definition of capital.15

Unlike Piketty, Maito leaves out residential property and financial
assets, and correctly categorises capital as the value of the means of
production owned and accumulated in the capitalist sector. The result is
not some steady r, but a falling rate of profit à la Marx. There is a long-term decline, but there are various periods when the rate of profit rises or consolidates.16

I used Piketty’s own voluminous data for Germany to compare his rate
of return with Maito’s Marxian rate of profit for that country since the
1950s. Piketty’s data produce a similar result to Maito’s. The rate of
return for Germany falls from 1950 and then stabilises from the 1980s.
This is because Germans have a much lower ownership of residential
property. Only 44% of German households own their own homes, compared
with 70%-80% in Greece, Italy and Spain. When residential property is
not a large share of ‘capital’, Piketty’s and Marx’s r move in much the
same way.

The good and the bad
Piketty shows compellingly that inequality of wealth and income is
getting higher in most capitalist economies. The reason is a rise of
income going to capital in the form of profits, rent and interest and
not due to the more skilled labour getting higher income than the less
skilled. And the rising capital-income ratio is driven mainly by
inherited wealth. ‘From rags to riches’ is not the story of capitalist
wealth: it is more ‘From father to son’ or ‘From husband to widow’.

But then Piketty tries to develop some “fundamental laws of
capitalism” and comes a cropper. He conflates capital into wealth by
including non-productive assets like housing, stocks and bonds in his
measure. In doing so, he loses sight of how wealth is created and
appropriated, as Marx shows with his law of value. And his net rate of
return on capital becomes separated from the capitalist process of
production. Indeed, if you strip out housing and financial assets from
his measure of the rate of return, you get Marx’s rate of profit and it
falls (and moves up and down), unlike Piketty’s “steady” r.

As a result, Piketty has no theory of crises in capitalism and
assumes they are passing phenomena. So his policy prescriptions for a
better world are confined to progressive taxation and a global wealth
tax to ‘correct’ capitalist inequality. Yet Piketty recognises that it
is utopian to expect the wealthy (who control governments) to agree to a
reduction in their own wealth in order to save capitalism from future
social upheaval. He never thinks of suggesting another way to achieve a
reduction in inequality: namely, to raise wage income share through
labour struggles and to free trade unions from the shackles of labour
legislation.

And he does not raise more radical policies to take over the banks
and large companies, stop the payment of grotesque salaries to top
executives and end the risk-taking scams that have brought economies to
their knees. For Piketty - in true social democratic fashion - the
replacement of the capitalist mode of production is not necessary.Michael Roberts
Michael Roberts is author of The great recession: a Marxist view, published by Lulu (2009). His next book, The long depression, is forthcoming. He regularly blogs at thenextrecession.wordpress.com.

Notes

1. B Milanović, ‘The return of patrimonial capitalism’ - review of Capital in the 21st century, World Bank, October 9 2013, draft for Journal of Economic Literature, June 2014.
2. P Krugman, ‘Why we are in a new gilded age’ The New York Review of Books May 8 2014.
3. M Wolf, ‘Capital in the 21st century’ Financial Times April 15 2014.
4. J Cassidy, ‘Forces of divergence’ The New Yorker March 31 2014.
5. www.nytimes.com/2014/04/20/business/international/taking-on-adam-smith-and-karl-marx.html?_r=0.
6. Interview with New Republic: www.newrepublic.com/article/117655/thomas-piketty-interview-economist-discusses-his-distaste-marx.
7. http://blogs.ft.com/money-supply/2014/05/23/piketty-response-to-ft-data-concerns.
8. http://thenextrecession.files.wordpress.com/2014/05/pikettyzucman2014hid.pdf.
9. Now in an open 10-page letter posted online,
professor Piketty defends his use of data and his overarching
conclusion:
http://piketty.pse.ens.fr/files/capital21c/en/Piketty2014TechnicalAppendixResponsetoFT.pdf.
He argues that apparent transcription errors were deliberate
adjustments and he defends his use of certain data sources over others.
10. See R Ibbotson and R Sinquefield, ‘Stocks, bonds, bills and inflation: year by year historical returns’ Journal of Business January 1976.
11. See B Eichengreen Project Syndicate April
27 2014. He refers to International Monetary Fund data showing that the
real interest rate on bonds has been falling for three decades and, at
2%-3%, is hardly above the potential growth rate of the major
Organisation for Economic Cooperation and Development economies.
12. James Galbraith argues that Piketty “conflates
physical capital equipment with all forms of money-valued wealth,
including land and housing, whether that wealth is in productive use or
not. He excludes only what neoclassical economists call ‘human capital’,
presumably because it can’t be bought and sold. Then he estimates the
market value of that wealth. His measure of capital is not physical but
financial” (‘Capital for the 21st century?’ Dissent spring
2014). This leads to problems of measurement as asset prices are
volatile, although Piketty claims that they are not over the long run.
13. See R Solow, ‘A contribution to the theory of economic growth’ Quarterly Journal of Economics February 1956.
14. “At least since Wicksell it is well known that
capital goods cannot be measured and aggregated in physical units
because of their heterogeneity: how does one add up an airplane and a
printing machine? Therefore valuation measures must be used. The value
of a capital good can be the cost of its production or the value of the
output that it will produce in the future. Both approaches require an
interest rate (discount rate), but that interest rate is usually
determined by using the amount of capital in relation to output” (S
Bergheim Long-run growth forecasting 2008).
15. E Maito, ‘The historical transience of capital,
the downward trend in the rate of profit since the 19th century’:
http://thenextrecession.wordpress.com/2014/04/23/a-world-rate-of-profit-revisited-with-maito-and-piketty.
16. See Piketty’s tables for Germany at http://piketty.pse.ens.fr/fr/capital21c.